Sunday, July 12, 2009

Inflation, the potential stealth tax

Be wary of the stealth tax inflation can hide. It doesn't just destroy dollar-denominated wealth. In a progressive income tax system, such as we have in the US, inflation destroys real income even when that nominal income is effectively indexed for inflation if tax brackets do not undergo an increase corresponding to the increases in inflation and incomes.

For example, if the tax rate is 10% up to $10,000 and 20% for each dollar earned over $10,000, if in year 1 you earn $10,000, you pay $1,000 in taxes. If 50% inflation occurs in year 2, you're now making $15,000. Everything costs 50% more, so it's a wash, right? Except now you are paying $2,000 in taxes--100% more than the year before.

Over the last few years, tax rate schedules have increased at about 3% annually, approximately in line with CPI-measured inflation. But if the leviathan needs to be fed and the farmers and fishers are caught in a secular cycle of declining harvests, its tenders will look for creative, undetectable ways of sucking the necessary sustenance out of the baskets of the producers to grow the beast.

14 comments:

Interesting post. How come this isn't something that gets more exposure?

The press isn't aware/interested because they are a bunch of innumerates and economic illiterates. The gov't isn't interested for the obvious reasons. The press has become the Dept of Propaganda for the gov't.

About a year ago I found a site about how the CPI was changed during the Clinton administration.

http://www.shadowstats.com/

If you didn't see the WSJ article last week about the state of Montana soliciting actuaries to make non standard calculations to certify their pension plans, I will just mention that actuaries were talking about that among themselves three months ago. Pensions right now are looking like the next bubble to burst.

Who cares? What does that have to do with inflation?

Well, the only way to pay those benefits will be to hold salary increases down until people retire because defined benefit plans are calculated on the average of the last 3-5 years. Then they just allow inflation to do the rest. That is pay the retirees in $ worth far less. The CPI was recalculated specifically for this reason. Those of you who are older will remember this.

Back in 2002 Bernanke gave a speech where he said he would print money to create inflation. Now that he is Fed Chair, I don't think he has a new opinion.

David,

Why not more exposure?

Ratings.

Imagine how fast the viewers would change the channel if the news anchorman said, "Here is the latest from the state of Montana:

The board determines the valuation method for discounting liabilities to their present value, and it uses actuarial valuation, currently 8%, based on the long-term assumed rate of return of assets, Mr. Miller said.

Tax law is notoriously hard to read but from what I can tell the IRS pretty much has their hands tied when it comes to the income cutoffs for the brackets - they have to adjust them in line with the CPI every year. This is not to say that the powers that be couldn't get around this constraint, though. They'll get their money (at least enough to keep spending) one way or another.

Silly girl, what's with your obsession with public pension plans? Are you an actuary or something? I'm only asking because my job involves the workings of public pension plans.

Measuring income growth is a bit tricky because economists also have to take into account increases in benefits - not just wages.

For example, wage growth was slow this decade primarily because of the rising cost of health insurance. Money that otherwise have been used as extra bonuses and wages for employees instead got soaked up by insurance premiums.

I have always been skeptical of perpetual growth models. We know that Social Security is not going to work long term. So I wondered about pension schemes. Rather than look for BS in the media, I decided to check out the gossip among actuaries. Using a similar strategy on other topics, I found HBD folks. I am profoundly skeptical and I don't believe what people tell me. I don't like the reasoning of "just because". Things happen for a reason. I want the reasons. Someday I will be old and I want to know what is going on with the pension schemes. It is more interesting to me than Britney Spears lipstick. I would like to know the factors affecting the future, and no, I don't believe the nice lady in the HR office.

Mass failure of pension schemes could be just as bad as the collapse of the housing market. Maybe even worse. I am willing to face such a possible reality, but preferably before it happens so I can come up with a plan.

Proactively conflating inflation with increased taxation in a hypothetical context? Helen Thomas and Chip Reid are still a long way from being that brazen!

Rosita,

Great to hear. Why block public access to your own?

Silly girl,

Have you seen this? In light of your comments, you might find it funny (though not encouraging).

Jokah,

I'm embarrassed to say I am not sure how the yearly schedules are constructed although I suspect it is provided in the most contemporaneous tax legislation. But brackets do not grow at exactly parallel rates from year to year, so it is not set across the board to a CPI figure. The cut-offs grow faster at the lower end than they do at the high end, at least that has been the case for the last few years. I'll try and find out explicitly how they are arrived at.

Interesting theory, except that tax brackets are indexed to inflation, so in year two you'd still be paying 10% tax on your entire income since the bracket would have moved up by 50% along with your income.